Why Balance Sheets Matter

By D.W. Haney, CPA (Retired)

Most HOA disputes, dysfunctions, and disruptions are due to financial and standard of care stewardship issues. Who pays what, when, and why? And unfortunately, HOA financial statements produced today are misleading and fail to reflect the community’s economic reality.

In general, HOA directors, managers, and advisors do not have the skill sets necessary to understand, analyze, and respond to the financial statement stories contained in GAAP (Generally Accepted Accounting Principles) compliant financial statements. These statements are a foreign language to most, who oftentimes do not seek the advice of financial translators and guides to help them on this important piece of the HOA journey.

One big piece in this puzzle is the Statement of Financial Position (balance sheet). Here we will examine the three different methods to tell the financial strength story: cash basis, full accrual, equity designation. (There is a fourth method on the scene right now—contract liability. Because this method is fatally flawed it will not be discussed.)

HOAs should adopt the full accrual method for future periodic (non-annual) Major Repair & Replacement (MRR) obligations. The equity designation method is a close second. The cash basis (and contract liability method) should be disregarded. They are misleading and fail to reflect the community’s economic reality. CID leadership, managers, and advisors should continue to develop their financial literacy level.

The full accrual method best displays the community’s future MRR obligation and its current funding position. Underfunded situations are clearly disclosed to HOA stakeholders in the members’ equity section of the balance sheet, and the plan to cure should be well known and over communicated to all HOA stakeholders all the time. It is the strongest indicator of HOA financial strength or weakness and should serve as the basis for all future funding and budgeting dialogue and debate.

Exhibit A has three columns that display the differences among the methods as follows:

Case 1-Legacy or Cash Basis is an actual CPA financially reviewed CID balance sheet at 12.31.21 using the Legacy or Cash Basis method. This method is the dominating reporting method in the U.S. today.

Case 2-Liability Accrued is the same balance sheet that treats the MRR obligation as a probable and reasonably estimated third-party liability using the information provided by the MRR study.

Case 3-Equity Designation is the same balance sheet that treats the MRR obligation as a CID board of directors’ designation of Members Equity using the information provided by the MRR study.

The balance sheet shows the things the entity owns (assets), the third-party claims on those assets (liabilities), and the ownership claims on those assets (in this case members’ equity). Total Assets equal the total claims on those assets; hence, the term balance sheet, and professionally labeled "Financial Position Statement."

The members’ equity section is divided into two groups: Designated and Undesignated. The Undesignated can be considered the available net assets not otherwise committed to projects or purposes. Total Undesignated (Deficit) Members’ Equity" (Lines 42 and 43) are the important lines.

In Case 1, the message is that the HOA has a positive undesignated equity of $124,117. Absent any other information, the lay reader would conclude that the HOA is financially strong. To most readers $124,000 is a lot of money. Why are assessments so high?

In Case 2, the message is that the HOA has a deficit undesignated equity of $723,837; clearly there is a funding problem. How did that happen? Notice the activity in lines 25 to 29. An $847,954 reasonable estimate of the MRR obligation has been recorded. The source for this estimate is the MRR study, commonly known as the "Reserve Study." The credibility of these estimates is a topic for another day. However, the Financial Accounting Standards Board (FASB), the U.S. Accounting Standards setting body, has opined that a good estimate is better than no estimate and that the estimates will get better as more attention is paid to them.

In Case 3, notice on lines 31 to 38 the Members’ Equity Designated section various line items that the governing body could at its discretion "designate" Members’ Equity for specific purposes. PMThere are differences among professional accountants about whether these MRR obligations rise to the level of third-party claims on assets; a professional loose end. This option shows the MRR obligation as a Members’ Equity designation. The effect on line 42 is the same as Case 2.

Case 1, Cash Basis, is clearly misleading and fails to reflect economic reality. It should be replaced by Case 2, Full Accrual. Case 3, Equity Designation, is an acceptable alternative.

If you would like to explore this topic in more depth, please contact me to obtain the academic and professional standards supporting these concepts and techniques.

D.W. Haney is a retired managing member and counsel to the leadership team of CiD Consortium, LLC, a CID management, finance, and consulting company. He has been questioning the status quo and improving business processes in HOAs for more than 40 years.